7/17/2008 @ 6:00AM

Expect More Crisis

IndyMac
has failed.
Fannie Mae
and
Freddie Mac
have been hobbled but kept alive by a government and Federal Reserve rescue.

All of this happened just weeks after President Bush and Treasury Secretary Hank Paulson claimed that the worst of the credit crisis had passed. Don’t believe anyone who tells you that the worst is over until the banks, insurance companies, investment funds and mortgage companies that hold securitized debts fess up to what those securities are actually worth. The problem isn’t that the securities are illiquid, it’s that the prices should be lower than the financial institutions are willing to admit.

Probably by the end of the month,
Goldman Sachs
will auction off assets from a $7 billion structured investment vehicle that was previously owned and managed by Cheyne Capital Management, a London hedge fund shop that faced massive losses this summer when its commercial paper went illiquid. The Goldman auction might give us a clue about how inflated these assets are, despite the more than $400 billion in write-downs that banks have taken since the credit markets went south last summer.

Throughout the industry and around the world, investment banks and other financial companies that own structured mortgage securities have advanced the fiction that because the market for these securities is illiquid that they have no fair market value. Up until August 2007, when banks were able to sell these securities at attractive prices, they marked the securities to market, just as they would with a liquid stock. When prices plummeted, the banks ignored the inconveniently low “buy” prices and decided to price them based on their own secret algorithms. Mark-to-market has given way to mark-to-model.

Since every multinational bank is playing the same game, and every bank has a different model, we’re seeing banks give different prices for identical securities. What
Morgan Stanley
might say is worth $0.80 on the dollar could be worth $0.60 to Goldman Sachs. Who’s right? Nobody knows. But this is why LIBOR, the lending rate between banks, has shot up despite lower Fed Funds rates–the banks no longer trust one another, even on overnight loans.

The banks claim that since the securities aren’t trading, these models are appropriate. But even in the absence of a trade, bid/ask prices exist for all marketed products. A conservative firm will usually mark an illiquid position to an average of three “bid” quotes. The banks will counter that they don’t intend to sell these securities for the current bids. But they might not have a choice. A leveraged institution like a bank–and the investment banks have leverage in excess of 30-to-1–doesn’t always get to decide when it’s going to sell securities.

Marking-to-model is so subjective and secretive that it practically begs bankers to commit fraud. Traders who work on proprietary trading desks almost always report different prices for the same security that was being held in another department of the bank, such as the asset management department for a fund managed for clients. In some cases, a bank allows such inconsistencies because it has spent millions to hire a star trader and doesn’t want to look like an idiot for doing so.

Banks use third parties like State Street to build models for valuing these securities when they’re in client or mutual fund accounts. But sometimes clients or account managers disagree with their contractor. When that happens, the manager or client might push for a different valuation, and they usually get their way. The third party can only proffer a number; it can’t force anyone to accept it.

So long as the banks refuse to mark their securities to market (a task they claim is impossible), investors will have to blindly navigate the credit crisis. There’s too much fog for us to be able to tell if we’re on the near shore, the middle of the river or nearing the next bank. Definitely watch Goldman’s auction. It won’t change anything, but it will offer some clues as to how much more pain will have to be endured.

Ann Lee is an adjunct finance professor at Pace University and a former bond trader.